Do adjustable rate mortgages offer any protection against rising rates?
Yes. ARMs and other variable rate or payment plans offer lower-than-market interest rates initially, but because they are tied to the interest rates of U.S. Treasury Bills or other indexes, interest rates later in the loan term may rise. However, many such loans offer built-in safeguards designed to minimize the effect of any rapid escalation in interest rates.
One such safeguard is the rate cap. Many ARMs include provisions for the maximum amount your rate can rise, both annually and over the life of the loan. For example, if your initial rate is 8%, the loan may include 1 % annual and 5% lifetime caps ... which means even if rates rise dramatically, you'll pay no more than 9% next year, 10% the following year, and so on until a maximum rate of 13 % is reached. ARMs may also allow your rate to decrease when the index it is tied to goes down. As you might expect, decreases are usually capped as well.
A second protective device included in some ARMs is the payment cap. Under this provision, your monthly payments may rise by only a set dollar amount. The potential disadvantage of this type of cap is that it can slow or even reverse your equity build-up. If rates rise dramatically, you could actually wind up owing more principal at the end of the year than you did at the beginning.